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Running Out of Options

Corporate Research E-Letter No. 37, July 2003

RUNNING OUT OF OPTIONS: WHICH WAY FOR CORPORATE AMERICA?

By Mafruza Khan

Earlier this month, Microsoft Corp. announced that it would abandon the practice of awarding stock options to executives and workers. Starting in September 2003, employees will be granted stock awards (also known as restricted stock units) instead of stock options. The company said that stock awards offer employees real ownership and greater long-term financial incentives and better link senior employees' total compensation to corporate performance. The company also announced that it would account for stock-based compensation as an expense on its income statement for fiscal 2004, including previously granted stock options. The company's dramatic announcement, which made front-page news, re-ignited two related debates: whether options or stocks better link compensation to company performance; and whether options should be expensed when they are granted.

Along with the recent surge in shareholder activism, Microsoft's pioneering steps are expected to influence the way compensation packages will be styled and accounted for in corporate America. But the company's high-tech peers are not jumping on to the Microsoft bandwagon. As the Los Angeles Times notes, "Microsoft's dramatic decision to dump stock options hasn't led to a flood of imitation in Silicon Valley, ground zero of the stock-option culture. Big name tech firms such as Oracle Corp., Cisco Systems Inc., Intel Corp. and Dell Computer Corp. were quick to say they remain committed to options." Most high-tech companies are also fierce opponents of expensing options.

Unlike stock options, which gain value only if the company's stock price rises, restricted stock awards represent an actual gift of shares. By contrast, stock options give holders the right to buy shares at a fixed price after a specific date. Unlike all other forms of compensation, stock options are not usually counted as an expense when computing profits, but they are tax-deductible. The estimated 9,000 Microsoft millionaires helped options become a defining characteristic of the bullish nineties. Executives got obscenely rich, companies lowered their taxes, and (almost) everybody was happy.

The option fad even permeated popular culture. As a July 21 Newsweek article points out, when Sean Ambrose, the villain in the movie "Mission Impossible II," held the fate of the world in his hand, he didn't demand cash or even stock. He wanted stock options.

HOW DID WE GET HERE?

In the last two decades, there have been dramatic changes in the way U.S CEOs are paid. The option explosion is the central and most controversial development in CEO compensation that has affected the level of pay, the composition of that pay and the incentives that Top executives are offered.

In the 1970s and the early 1980s, U.S CEO's received relatively little equity-based pay and, as a result, had limited ownership stake in the companies they managed. The financial incentives for U.S executives changed dramatically with the increase in takeovers and takeover threats that started in the mid-1980s. Moreover, management buyouts - which virtually always led to large increases in the ownership stakes for Top managers - increased dramatically. In his testimony to the Senate Commerce, Science and Transportation Committee in May, Brian Hall, an associate professor at Harvard Business School, stated that buyouts were typically quite successful in raising efficiency, productivity and company profits. While many would argue to the contrary, the use of equity-based pay did begin to spread throughout corporate America during that period. Following the rise of institutional investor influence and the subsequent entrepreneurial wave of the 1990s, stock options became the norm, especially among high-tech companies. As recently as 1984, fewer than half of the CEOs received any option grant at all. In recent years, option grants have been on average about twice as large as cash-based pay and make up about two-thirds of the value of the total compensation package.

Microsoft's dramatic decision has significant implications for corporate America. A Federal Reserve study found that if stock options had been expensed between 1995 and 2000, annual corporate earnings growth would have been just 5%, not the 8.3% reported. Merrill Lynch has estimated that had options been expensed, earnings for the S&P 500 would have been 21% lower in 2001, and 39% lower in the information technology sector.

Companies regularly deduct the cost of exercised stock options when filing their tax returns. Yet, if options are considered an expense for tax purposes, why are they not also considered an expense when it comes to financial statements? This disparity, according to Tax Notes, allowed U.S. corporations to deduct a remarkable $56 billion for stock options in 2000, up from $42 billion in 1999 and $28 billion in 1998. Microsoft and five other Top US tech firms paid no federal tax because they deducted some $10 billion in exercised options. To make matters worse, in 2001 the IRS issued Revenue Ruling 200-1. This states that the alternative minimum tax, which requires corporations with extensive deductions to pay a minimum tax, did not apply to companies, which reduced their taxes using stock options deductions.

PROPONENT AND OPPONENTS: THE ARGUMENTS

The value of executive stock options comes partly at the expense of all other shareholders. The more company shares are issued, the less each share will be worth because the earnings per share will be reduced. So every time options are issued, the value of outstanding shares declines. Options require no cash expense up-front, even though the dilution cost is economically equivalent. Business Week estimates that 16.3% of all outstanding shares at large companies are in the form of options.

There are several major drawbacks to options as they have been traditionally awarded to CEOs and other Top executives. Supporters of options were of the opinion that they would increase the financial stake of the CEO in the company. But since options only gain value if the company's stock price rises, they create an obsessive interest in the current price at the expense of the long-term performance of the business. Options don't create long-term stock ownership, as CEOs are usually only interested in making a quick buck by exercising their options when stock prices are high. In 2001 Oracle Corp. CEO Larry Ellison exercised a whopping $706 million in options. The same year his company’s stock dropped 50%. Had he and other Oracle employees receive cash instead of options that year, Oracle's operating income would have declined by $933 million.

While broad-based options are potentially an effective management tool to reward hard-working employees with a piece of company ownership, the vast majority of stock options, unfortunately, go to a handful of Top executives. According to the Bureau of Labor Statistics, only 1.7% of non-executive workers got any stock options in 2000, a banner year for options. According to professors Joseph R. Blasi and Douglas L. Kruse, the authors of “In the Company of Owners: The Truth about Stock Options,” about 30% of options go to the Top five employees, and the other 70% are “spread narrowly among other executives and managers.” From 1992 to 2001, the Top five executives of the largest 1,500 U.S. companies made $67 billion in stock-option profits.

The high-tech crowd argues that it has a good reason for its heavy use of options: its members distribute them more democratically than the rest of corporate America. But as former SEC Chairman Arthur Leavitt correctly points out: "While I can appreciate how very special high-technology companies are and how much they've contributed to the economy, they still operate in the same environment of public confidence. Basic standards of transparency and disclosure still must apply."

Opponents of expensing argue that options should not be expensed because granting them doesn’t have a direct cost. But as investing guru Warren Buffett explains: “If stock options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world do they go?”

The International Employee Stock Options Coalition (IESOC) has led the fight against the expensing of options. The coalition includes big high-tech players like the National Venture Capital Association, and TechNet, which include industry heavy hitters such as Cisco and Intel. They argue that expensing options will damage their competitiveness, and if they wanted to expense options, no valuation model exists to place an accurate price tag on them. The right course of action, according to the technology companies, is simply better disclosure. Those in favor of expensing options disagree, though they agree that current valuation tools are not perfect.

WINNING THE BATTLES AND THE WAR

Proponents of expensing options had a major victory in late April when the Financial Accounting Standards Board (FASB), the private body that writes the general rules governing accounting practices, voted unanimously to require companies to expense stock options. FASB plans to issue a final standard by April 2004. The Board had attempted to institute a similar rule in 1995, but dropped it under intense political pressure. Industry observers think that it stands a better chance this time, given recent corporate scandals. So far, more than 200 companies have announced that that they are going to expense options, whatever the final outcome at FASB.

In another victory for shareholder rights activists, the New York Stock Exchange and the Nasdaq adopted rules requiring U.S.-listed corporations to start submitting stock-based pay plans to shareholders for a vote, including stock-option plans. The rules have been approved by the SEC.

There has also been proposal on this issue in Congress. Earlier this year the Broad-Based Stock Option Plan Transparency Act was introduced in the Senate and the House. The bill directs the Securities and Exchange Commission to require enhanced disclosures of employee stock options, and to require a study on the economic impact of broad-based employee stock option plans. Groups such as Citizen Works are opposing the bill because it would derail the recent decision by FASB to require stock options to be expensed.

THE 2003 PROXY SEASON AND THE STAKES FOR SHAREHOLDERS

Recent corporate scandals and excessive executive compensation have been reflected in shareholder action during the current proxy season. The labor movement, which is leading a shareholder assault on what it sees as executive excess, has seized on Microsoft's announcement to turn up the heat on other firms. Of the 112 shareholder resolutions on expensing options tracked by Investor Responsibility Research Center so far, all but three were submitted by union funds. Complete voting results are not yet available; but several dozen have been approved by shareholders (though it should be kept in mind that shareholder resolutions are non-binding even if they win).

Among the companies where the resolution was passed, are Flour, Georgia Pacific, Capital One Financial, and Delta Air Lines. At Apple, shareholders approved the resolution, but the board rejected the shareholder vote, saying it would only expense options once FASB issues its final rule. At Intel, the resolution did not win but got 48 percent of votes, with management opposing the proposal.

CONCLUSION

It is not yet clear how much Microsoft's new compensation policy will ultimately have on the options debate. Options may not disappear anytime soon; but it is becoming increasingly difficult to justify executive compensation and accounting practices that vastly enrich a tiny number of Top executives at the expense of shareholders and taxpayers.